Citi Warns Bond Bulls "QE Is Dead... Long Live Normalization"

Despite the total collapse (flattening) in the Treasury yield curve in the last 2 days, Citi's FX Technicals group is convinced that we have seen a turn in fixed income that will see significantly higher yields in the years ahead and notably higher yields by this yearend also. Furthermore, they believe this will initially come from the belief in a continued taper, and the curve will initially steepen (2’s versus 5’s and 2’s versus 10’s). This normalization, they add, will be a good thing - QE encourages misallocation of capital and poor business decisions which has a negative feedback loop into the economy - but add (as long as yields do not go too far too fast like last year).

Citi FX Technicals,

We continue to expect a return to test and likely break the trend highs posted in Sept 2013 (2 and 5 year yields) and Jan 2014 (10 and 30 year yields)

2’s versus 5’s chart (One of our favourite charts of all time) making a comeback?

This is a chart that we have historically referred to as “the best interest rate chart in the World”

On 3 occasions in the last quarter century we have seen this chart go to +161 basis points and on 3 occasions we have seen it move to the area around -20 basis points. In 5 of those 6 periods we have seen this being a precursor to a shift in Fed policy.

The exception to this rule was when we turned off the +161 level seen in 2009. In the prior 2 occasions the flattening off this level was a “bear-flattening” as the market anticipated that we were moving to a tightening in Fed policy (Just as the rises from inversion were bull steepenings as the market anticipated an easing of Fed policy.)

The flattening we saw from the 2009 peak was NOT a bear flattening and it was NOT the market anticipating a Fed tightening but quite the contrary. The flattening was “interference”, more commonly known as QE. This caused the curve to bull flatten as Fed monetary policy moved to the long end of the curve….so it really was “different this time”

However, in early May 2013 as this curve stood around +45 basis points we got the very first compelling suggestion from the Fed (Ben Bernanke) that this ultra-loose unorthodox monetary policy may have served his purpose and that tapering may come into play (Not a moment too soon in our view)

Since then the curve has been “bear steepening”. Some people (the Fed included) will tell you that this is not tightening. Wake up call- If the part of the curve you are now playing in moves up in yield because of what you (the Fed) has said or done then you have been responsible for a tightening in monetary conditions. That is ok. It is the right thing to do, but call it like it is.

So long term rates are “normalizing”. Normalizing is not the “dirty word” that most people would like you to believe. Normalizing is a good thing. It starts to discourage misallocation of capital. It stops mispricing of risk. It forces companies to make investment/business decisions. It allows financial markets to function. Normal is better than abnormal.

So with the Fed “moving out of the way” long term yields headed higher and the curve above steepened again. We had no real concern with that, although felt that the initial move was “too far too fast” and might create a drag that would need time to offset.

In mid-March (A week after our bulletin on 07 March titled “Major reversal higher in US yields looks likely”) 10 year yields stood at 2.60%-Just shy of our 2.50% target expressed at the start of the year and just above the low of this year’s down move at 2.57%. More importantly that was the same level we had seen in last year’s up move by June 2013.

So after the initial surge in yields we have had the correction/consolidation necessary to “work that move off” (relatively unchanged levels for about 9 months) and set the platform, in our view, for the next move higher.

So what do we expect now?

We expect the curve above to further steepen as 5 year yields head higher more aggressively than 2 year yields. That is because at this point Fed policy is changing at the longer end of the curve but not YET at the Fed funds level.

We would not be surprised if we see this curve head right back to 161 basis points again as Fed interference becomes less and less.

At that point, looking at the historical perspective, we would expect the bear steepening to then “morph” into a bear flattening as the market begins to realize that the timeline for a move by the Fed on the Fed funds rate is not going to be as long as they thought.

At that point 2 year yields are going to head sharply higher and rise at a pace greater than 5 year yields causing the curve to bear-flatten in a traditional type of way

US 2 year yield: New highs in the move look imminent

Following the recent 76.4% pullback the 2 year yield is now re-testing the Jan high at 43 basis points.

A close above would suggest gains towards the channel top at 59 basis points quite quickly.

A close above here would suggest that it could revisit the 2011 peak around 88-89 basis points.

US2 year yield minus Fed funds- Has it just become relevant again for the first time in 7 years?

Going back to the start of the Fed PUT era (beginning with Alan Greenspan, the Ben Bernanke and now Janet Yellen) all policy changes from the cycle low/high in the Fed funds rate have been preceded by a large gap opening up between the 2 year yield and the Fed funds rate ). This gap has regularly been in excess of 100 basis points before the Fed capitulates and moves short-term rates. (Including in 2007)

This may well suggest that we are going to have to see that break of 89 basis points on the 2 year yield and a move towards that 1.43% level before the Fed capitulates on the Fed funds rate (That normally happens earlier than they would guide) and raises short term rates.

If we look at the present Fed funds rate (Zero-25 basis points) this suggests that once we start heading into the 1.20-1.50% range in 2 year yields that a Fed hike is likely pretty imminent. As we mentioned above, we believe that a break of 89 basis points on the 2 year yield may well be the early warning sign that this development is materializing.

1994, 2004, 2014????. Might the shock be that the Fed could be grudgingly tightening by late 2014 (An equal time line to the 1994-2004 gap would suggest end November 2014) just as it was grudgingly easing by late 2007 despite being quite hawkish earlier that year?

Posted an outside week 2 weeks ago (As did every part of the curve from 2 year to 30 year yields) suggesting higher yields are in prospect.

We saw this in July 2012 and again in April 2013 as weekly momentum turned up.

That was a precursor to low to high moves of 70 and 144 basis points respectively (Average of about 107 basis points over 8 months).

If repeated, that would suggest the following by later this year (November)

– A repeat of the 2012 move would take us to 3.29%– A repeat of the average would take us to 3.66%– A repeat of the 2013 move would take us to 4.03%

A move through the double highs at 3.00-3.05% (Sept-Dec 2013) would suggest a topside acceleration. The top of this channel stands at 3.59% but is rising sharply and will converge with the horizontal resistance around 3.77% in early May.

US 10 year yield monthly chart- Back to test the channel top?

Along with the good resistance at 3.77% (Feb 2011 high) we have some good levels above there

– 3.80-3.85%- Long term channel top going back 20 years– 4.00-4.01%- double top from June 2009/April 2010– 4.27%- June 2008 peak– 5.25-5.32%- 2007 cycle peaks

We are certainly convinced that we will go and re-test that area around 3.77-3.85% (Probably this year) with the potential to head higher still.

Citi's optimistic conclusion:

We have said for a very long time that we were “optimists” on the US coming out of this downturn but that it was going to take longer than people thought. For many years the phrase “green shoots” was used only for hopes to be dashed.

Are we growing as much as we would like? No

Has employment improved as much as we would like? No

Has housing strengthened as much as we would like? No

But the “Green shoots” are definitely there now and need to be “nurtured” by normalization not “flooded” by QE.We believe ending QE and then moving into a more normal interest rate environment that rewards all savers rather than the marginal borrower, that forces businesses to make business decisions, that encourages risk adjusted allocation of capital and more thoughtful Capex decisions is unequivocally positive.

We applaud Janet Yellen’s bold comments yesterday and encourage her to “hold the line”. It’s the right thing to do, not necessarily the easy thing to do. If her Fed does that it may well be the first Fed since Paul Volcker that has had the nerve to do so and we feel sure that it will culminate in a more positive outcome than the 5 ½ years of misguided QE has yielded.

Agreed! How can rates move up when people like foneystar are indebted to their eyeballs in student loans.... Rates are going lower... much lower so there is a hope in hell that people, like foneystar, can keep borrowing to keep buying...

The fed can move the fed funds rate where ever they want, but the market will determine the real rates.... As much as I despise the US government, the amount of US bonds short and the lack of available tier 1 capital when the shit hits the fan makes me bullish US treasuries yet... especially the long end of the curve... lets see if flatening becomes inversion. Then the "real" economy will peak its head out of Yellen's ass...

You want to know where yields are going? QE Taper or Non-Taper? Just watch the budget deficit. QE was NOTHING but MONETIZING the DEBT! 2009/2010 Budget deficit explodes with Porkulus & 0zer0care, plus all the welfare payouts (unemployment, disability, EBT, etc). That leads to QE, Operation Twist, QE2, QE3, etc. Then the tea party comes along 2010/2011 and we get 2 years of sequester and budget fights. Now the tea party is co-opted by Rinos, and the deficit is set to explode again. Just look at the recent farm bill that was passed laden with pork. Now we have Minimum Wage Hike, more extended unemployment benefits, more Food Stamp payments, and best of all Amnesty. Already there are reports that the real federal deficit isn't $600M, but is really about $1T. Sequester is done. Budget fights are done. Soon, the tax receipts will flood in, and then it's all an orgy of spending going forward this summer. Throw in the MANDATED 0zer0care bailout to the insurance companies this fall, and we will be at $1T+ deficits this year. That's when QE-Taper will end. The excuse will be the "unexpected" economic slowdown, and the need for MOAR QE to stave off a "double dip recession". All so predictable. Printing is ALL TPTB have left. It will never stop. The Debt Ponzi Demands ZIRP!

Terminalization, more like. I read most everything as perception management these days in an increasingly desperate attempt to save the credibility of the so-called USD, really a digital FRN. US Dollar is defined in the Constitution and needs no saving because it actually is something of value.

You've always been one of the whiniest cunts on ZH when somebody doesn't agree with you/gee you're a fucking swell guy when someone does agree with you. Explain your love of the peg and why it's not for pussies. Because you know pegs and not free floating currencies (or interest rates, etc) are for pussies and that also means you support shit like Yellen and the Fed.

I suppose as long as the U.S can borrow 17 trillion plus and roll it over every 60 days the rest of the yield curve could be allowed to go higher. you have to wonder if the shove from intermediate bond funds into spy will be enough to offset the avalanche of home prices as mortgage rates rise and the real economy legs down further.

or quite possibly....no it can't be...maybe....nah....maybe citi will just get this wrong? Maybe like every fucking year since 2009 we will hear about higher rates and never see them.

So the fed debt has doubled in the past 8 years, last years deficit was larger than claimed by a couple bucks, and it looks to me like .gov is borrowing not only to pay entitlements and now bail out (effectively) large health insurers, but to pay the interest carry on existing debt...

But yields will follow a 25 year pattern?

I guess deficits truly do not matter, eh?

It would be interesting to see a chart of Goldmans profits overlaid on the top chart. Maybe not a tight correlation, but, hell it'd be interesting to see anyway.

If you see higher rates, you see buoyant, explosive GDP growth despite $100 oil (which only seems to warrant claim of affect on GDP when someone sees it has declined a bit, when it's up above $100, no impact noted).

If you see stagnant GDP growth, which is lower than the past 30 years, and rates have been falling for 30 years, then how do you see increased rates?

They don't no what will happen from SANTELLI on down! Been this way for 9 years and counting? Back in 06 they were all about inflation and dollar collapse same old shit? Rates go up to 6% and WHERE BROKE and doomed everyday since. Now they are desperate to be right even if rates go up and dollar doesnt collapse they will claim being half right to fill their bucket list!